Free Supplemental Brief - District Court of Federal Claims - federal

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IN THE UNITED STATES COURT OF FEDERAL CLAIMS __________ Nos. 01-256 T and 01-257 T (Judge Charles Lettow) MARRIOTT INTERNATIONAL RESORTS, L.P., MARRIOTT INTERNATIONAL JBS CORPORATION, TAX MATTERS PARTNER, Plaintiff v. THE UNITED STATES, Defendant. ______________________ SUPPLEMENTAL BRIEF OF THE UNITED STATES IN SUPPORT OF ITS MOTION FOR SUMMARY JUDGMENT AND IN OPPOSITION TO PLAINTIFF'S CROSS-MOTION FOR PARTIAL SUMMARY JUDGMENT ______________________ Defendant filed a motion for summary judgment on the question whether an obligation to close a short sale constitutes a liability for partnership basis purposes pursuant to § 752.1 Plaintiff filed an opposition to defendant's motion for summary judgment and a cross-motion for partial summary judgment. Defendant filed a brief in reply to plaintiff's opposition and in opposition to plaintiff's cross-motion for partial summary judgment. Oral argument on the parties' motions was held on May19, 2008. The Court subsequently requested that the parties file supplemental briefs on whether Regulation T as it stood in 1994 has implications for the

Except as otherwise noted, all sections cited herein refer to the Internal Revenue Code of 1986, 26 U.S.C., in effect during the periods in issue. -1-

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applicability of Section 752 to the transfer of the obligation to close the short sales pertinent to these cases. Introduction The United States asserts that under § 752, Marriott International Resorts, L.P. (MIR), must include in its partnership basis the short sale obligations it "assumed" from Marriott Ownership Resorts, Inc. (MORI), because the short sale obligations to replace the borrowed Treasury Notes are legal liabilities secured by the proceeds from the Treasury short sales, and the proceeds from the short sales quantify the amount of liability for purposes of § 752, irrespective of the term of the underlying securities. Regulation T Governs Short Sales Transactions Short sales are subject to extensive federal regulation. Levitin v. Paine Webber, Inc., 159 F.3d 698, 705 (1998). The Securities and Exchange Act of 1934 (the "Act") provides the general authority for the imposition of rules with respect to the extensions of credit by brokers and dealers to customers for the purchase or carrying of securities. 15 U.S.C. § 78g(a). The Act directs the Board of Governors of the Federal Reserve System to prescribe rules and regulations with respect to the amount of credit that may be initially extended and maintained by a broker or dealer on any security. Ibid. The Act gives the Federal Reserve Board authority to regulate short sales and the withdrawal by a customer of funds or securities. Ibid. Subsequently, Regulation T was issued by the Federal Reserve. The purpose of Regulation T is to "regulate extensions of credit by and to brokers and dealers; it also covers related transactions within the Board's authority under the Act. It imposes, among other obligations, initial margin

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requirements and payment rules on securities transactions." 12 C.F.R. § 220.1(a)(1994).2 Regulation T governs all short sales executed by United States broker-dealers. 12 C.F.R. §§ 220.1(a), 220.18(c) and (d). Under Regulation T, a creditor is any broker or dealer, and a customer is any person to or for whom a creditor extends, arranges, or maintains any credit. 12 C.F.R. §§ 220.2(b) and (c). Thus, Credit Suisse First Boston (CSFB) is a creditor and MORI is a customer for purposes of Regulation T. As a creditor, CSFB was required to maintain a record for MORI's account showing the full details of all transactions.3 12 C.F.R. § 220.3(a). MORI's short sale transactions were required to be maintained in a margin account.4 12 C.F.R. §§ 220.1(b)(1), 220.4(a), and 220.5(b). MORI was required to post initial margin for the short sales of Treasury Notes equal to 100 percent of the market value of the Notes--the short sale proceeds--plus any additional margin that may have been required by CSFB.5 12 C.F.R. §§ 220.5(b) and 220.18(d).6 Only items in MORI's margin account in which the short sales were conducted could be

The 1994 version of Regulation T is contained in the appendix hereto and all references herein are to the 1994 version unless otherwise noted. Thus, CSFB was required to document all account transactions including any withdrawal of funds or securities from MORI's account, 12 C.F.R. § 220.4(e), or a transfer of the account to another customer, 12 C.F.R. § 220.5(f)(2). The term short sale means any sale of a security which the seller does not own or any sale which is consummated by the delivery of a security borrowed by, or for the account of, the seller. 17 C.F.R. § 240.3b-3. The amount of the initial posted collateral is determined by the market value of the shorted securities, so any subsequent change in the value of the securities is irrelevant. Under Regulation T, a United States Treasury Note is considered an "exempt" security because it is a government security. 12 C.F.R. § 220.2(r); 15 U.S.C. § 78c(a)(12) and (42). By contrast, a "nonexempt" security requires a higher initial posted margin--equal to 150 percent of the market value of the security. 12 C.F.R. § 220.18(c). -36 5 4 3

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considered by CSFB to determine whether MORI had posted the required margin collateral. 12 C.F.R. § 220.3(b). Moreover, MORI was prohibited from withdrawing any funds or securities from its CSFB margin account if doing so would create or increase any margin deficiency. 12 C.F.R. § 220.4(e)(1)(ii). The practical effect of Regulation T on short sales was explained by the court in Levitin v. Paine Webber, Inc., 159 F.3d 698, 705 (1998): a broker who lends a customer stock for a short sale does not typically pay the proceeds of the sale to the customer to be spent when and how she wants, waiting for the customer to cover when and if it suits her. If a broker did that, the price might increase and the customer become insolvent or disappear, leaving the broker out the entire value of the stock-the price at the time of short sale plus its increase. Brokers therefore demand collateral, usually by taking an amount from the customer's account equal to the security required. The proceeds from the sale will, of course, usually be available as security, but if those proceeds and the balance in the customer's account are not sufficient to satisfy the security requirement, the customer will have to post additional collateral. The amount of security required is not entirely a matter for negotiation between broker and customer. The collateral posted must satisfy federal margin requirements associated with short trades. The Application of Regulation T to MORI's transactions In this case, MORI's short sales of Treasury Notes were executed through MORI's CSFB margin account. Pursuant to the requirements of Regulation T, MORI was required to post margin collateral at least equal to the market value of MORI's liability to CSBF to replace the borrowed Treasury Notes. Accordingly, CSFB held the proceeds from the short sales as margin collateral for MORI's binding, legal, obligation to replace the Treasury Notes.7 Similarly, after

There is no evidence that MORI substituted other collateral for the short sale proceeds to satisfy the margin requirements of Regulation T and it would be immaterial in any event. -4-

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MIR "assumed" the obligation to close the short sales, MIR could not have withdrawn the short sale proceeds which had been posted as initial margin collateral.8 Under Regulation T, a short sale is a secured transaction between a creditor and customer-debtor. Marriott's argument that a short sale obligation is a contingent liability is impossible to square with Regulation T's requirement that the full market value of the short sale liability be posted as collateral for the binding obligation to replace the shorted securities. The only way to characterize as "contingent" the absolute obligation to close a short sale would be to ignore Regulation T's long-standing requirements for the posting of margin collateral on short sales and the restrictions on the withdrawal of the collateral. Marriott's argument that a short sale is contingent because the precise amount of the eventual gain or loss on the short sale transaction is not known until the short sale is closed is irrelevant for the partnership basis calculation.9 Section 722 provides that the basis of an interest in a partnership acquired by the contribution of property to the partnership is the adjusted basis of the property to the contributing partner at the time of the contribution. Thus, whether there is a liability under § 752 which affects the partner's basis must be determined at the time the partner acquires its partnership interest by contributing property. Accordingly, the calculation of

For the purposes of the pending summary judgment motions only, the United States assumes that there was a "contribution" of the short sale proceeds to MIR and an "assumption" of the short sale obligations by MIR. It is an open question, however, whether the "contribution" and "assumption" actually occurred in manner that satisfies the transfer requirements of Regulation T. See 12 C.F.R. §§ 220.4(e), 220.5(f)(2); Def. Ex. 13 (short sale transactions in MORI's name after the purported contribution to MIR). Arguably, MORI did not "contribute" the short sale proceeds to MIR in the first place, so MIR could not have "assumed" the short sale obligations nor could MIR have closed the short sales. It is defendant's understanding that Marriott does not contest that it had a binding contractual obligation to return the borrowed Treasury Notes to CSFB, nor could it. -59

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MORI's partnership basis in MIR is determined at the time MORI acquired its partnership interest in MIR. Thus, MORI's basis in MIR must be determined at the time MORI "contributed" the short sale proceeds to MIR and MIR "assumed" the obligation to replace the borrowed Treasury Notes. Under Regulation T, when MORI entered the first part of the short sale transaction (selling the borrowed Treasury Notes), the amount of MORI's secured short sale liability to CSFB was equal to the amount of the short sales proceeds (the then-market value of the Notes sold). Regulation T required MORI to post that amount in the CSFB margin account to secure the liability to close the short sales and restricted the withdrawal of that amount. Therefore, for purposes of § 752, the liability to close the short sales was certain and quantified at that point and must be taken into account in calculating MORI's basis in MIR.10 In essence, Marriott argues that anticipated subsequent events may be taken into account in determining MORI's basis at the time it acquired its interest in MIR. There is no statutory provision, however, that allows a partner to calculate its initial basis in a partnership by anticipating subsequent events that might change the value of property contributed by a partner to a partnership. If a partner contributes a piece of machinery in exchange for a partnership interest, his partnership basis is based on his adjusted basis in the machinery. If the machinery becomes obsolete and worthless after the contribution, the partner's initial partnership basis is not changed by the subsequent change in the value of the machinery. It must follow then, that the partner cannot anticipate the possibility that the machinery may someday become worthless

This is consistent with the holding in Rev. Rul. 95-45, 1995-1 C.B. 53, that an obligation to replace shorted securities constitutes a liability under § 752, and the amount of the liability is the amount of the proceeds from the initial short sale transaction. -6-

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in calculating his initial basis in the partnership when he contributed the machinery to the partnership. Likewise, Marriott cannot use the possibility of a subsequent change in the value of the short sale obligation to effectuate an anticipatory adjustment to MORI's basis calculation by means of ignoring the short sale liability when MORI acquired its interest in MIR. MORI's obligation to close the short sales was a binding, legal obligation which was certain and quantified at the time of the contribution to MIR by the amount required by Regulation T to secure the obligation. Because MORI claims to have "contributed" the short sale proceeds to MIR in exchange for its partnership interest (so that its basis in MIR was equal to the short sale proceeds), the amount of the corresponding short sale liability must follow the "contribution." A short sale transaction is essentially identical to a conventional purchasemoney financing which clearly must be accounted for as a § 752 liability. Marriott's claim that the obligation to close the short sales is a contingent liability is controverted by Regulation T, which imposes a binding liability on a customer/debtor engaging in a short sale, which is quantified for § 752 purposes by the amount of the short sale proceeds. Accordingly, Marriott's claim that the short sale obligation can be disregarded a as liability under § 752 for partnership tax basis is groundless.

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CONCLUSION Based on the foregoing, defendant respectfully requests that its motion for summary judgment be granted. Respectfully submitted, s/G. Robson Stewart G. ROBSON STEWART U.S. Department of Justice - Tax Division Court of Federal Claims Section Post Office Box 26 Ben Franklin Station Washington, DC 20044 tel: (202) 307-6493 fax: (202) 514-9440 JOHN A. DICICCO Deputy Assistant Attorney General DAVID GUSTAFSON Chief, Court of Federal Claims Section s/David Gustafson Of Counsel Dated: June 6, 2008

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